The oxford handbook of capitalism

A M ERCANTILIST W ORLD E CONOMY Market economies flourished in many parts of Europe during the high and late Middle Ages, mostprominently in Italian commercial and manufacturing centers

THE OXFORD HANDBOOK OFCAPITALISM

THE OXFORD HANDBOOK OF

Edited by

DENNIS C MUELLER

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Library of Congress Cataloging-in-Publication Data

The Oxford handbook of capitalism/edited by Dennis C Mueller

p cm

Includes bibliographical references and index

ISBN 978-0-19-539117-6 (cloth :alk paper)

1 Capitalism—Handbooks, manuals, etc I Mueller, Dennis C

II Title: Handbook of capitalism

HB501.O97 2012330.12’2—dc232011034409

1 3 5 7 9 8 6 4 2Printed in the United States of America on acid-free paper

PART II THE NATURE OF CAPITALISM

4 The Four Types of Capitalism, Innovation, and Economic Growth

William J Baumol, Robert E Litan, and Carl J Schramm

5 The Dynamics of Capitalism

F M Scherer

PART III THE INSTITUTIONS OF CAPITALISM

6 The Role of Finance in Economic Development: Benefits, Risks, and Politics

Thorsten Beck

7 Property Rights and Capitalism

Paul H Rubin and Tilman Klumpp

8 Management and Governance of the Business Enterprise: Agency, Contracting, andCapabilities Perspectives

David J Teece

9 Contracts

Victor P Goldberg

PART IV PROBLEMS WITH CAPITALISM

10 Capitalism as a Mixed Economic System

Richard R Nelson

11 Monopoly Capitalism

Keith Cowling and Philip R Tomlinson

12 Agency Problems and the Fate of Capitalism

Randall Morck and Bernard Yeung

13 Executive Compensation: Governance and the Financial Crisis

PART V CAPITALISM AND THE STATE: DIFFERENT APPROACHES

16 Dispersed Ownership: The Theories, the Evidence, and the Enduring Tension between

“Lumpers” and “Splitters”

P REFACE

This handbook has three objectives: (1) to describe the advantages of capitalist sytems, (2) to discusssome of their disadvantages, and (3) to describe some of the differences in capitalist systems indifferent countries In putting this volume together, I have been fortunate in being able to work with agreat group of scholars

The original outline included two additional chapters: one discussing market competition, and asecond describing capitalist institutions in Europe Unfortunately, these chapters did not materialize.Because the first of these would have focused on the positive side of capitalism, its absence makesthe volume seem a bit more critical of capitalist institutions than was originally intended This biaswould have been even greater had Thorsten Beck not offered to write a second chapter on financialmarkets Despite the two missing chapters, I think the diligent reader will come away with a rathercomplete picture of capitalism’s pluses and minuses

In putting this volume together, I have been greatly aided by Heide Wurm, who has edited theessays and made sure that they are properly formatted I thank her for all of her efforts

C ONTRIBUTORS

Dennis C Mueller is Professor of Economics, Emeritus, at the University of Vienna Before coming

to Vienna, he was at the University of Maryland, College Park His research interests are industrialeconomic, public choice, and constitutional political economy

William J Baumol is Harold Price Professor of Entrepreneurship and Academic Director of the

Berkley Center for Entrepreneurship and Innovation at New York University and Senior Economistand Professor Emeritus at Princeton University

Thorsten Beck is Professor of Economics at Tilburg University and Chairman of the European

Banking Center, as well as a CEPR fellow Before joining Tilburg University and the CenTER, heworked at the Development Research Group of the World Bank

John C Coffee Jr is Adolf A Berle Professor at the Columbia University Law School, and

Director of its Center on Corporate Governance He is a Fellow at the American Academy of Artsand Sciences

Martin J Conyon is Professor of Corporate Governance and Finance at Lancaster University and

Senior Fellow and Lecturer at the Wharton School, University of Pennsylvania

Keith Cowling is Professor Emeritus at the University of Warwick His research interests are in

industrial economics, especially the deficiencies of monopoly capitalism, economics and democracy,industrial policy, and corporate governance and the public interest

Jeffry A Frieden is Professor in the Department of Government at Harvard University His research

focus is on the politics of international monetary and financial relations

Victor P Goldberg is Jerome L Greene Professor of Transactional Law at Columbia Law School.

His areas of research are law and economics, antitrust, regulation, and contracts

Tilman Klumpp is Assistant Professor in the Economics Department at Emory University His

research fields are microeconomics, applied game theory, public economics, political economics,economics of discrimination, and industrial organization

Robert E Litan is Vice President of Research and Policy at the Kauffmann Foundation.

Burton G Malkiel is Chemical Bank Chairman’s Professor of Economics Emeritus and Senior

Economist at Princeton University

Randall Morck is Jarislowsky Distinguished Professor of Finance and University Professor at the

School of Business at the University of Alberta His research interests are corporate finance,economic development, and political economy

Richard R Nelson is George Blumenthal Professor Emeritus of International and Public Affairs,

Business, and Law at Columbia University His research has concentrated on the processes of run economic change, with particular emphasis on technological advances and the evolution ofeconomic institutions

long-Hiroyuki Odagiri is Professor at Seijo University and Professor Emeritus at Hitotsubashi University.

His research interests are theory of the firm, industrial organization, and economic studies ofinnovation

Edmund S Phelps is McVickar Professor of Political Economy at Columbia University and Director

of the Columbia Center on Capitalism and Society He was the winner of the 2006 Nobel Prize inEconomics

Mark J Roe is David Berg Professor of Law at Harvard Law School His research interests are

corporate bankruptcy and reorganization, corporate finance, and corporate law He is a fellow of theAmerican Academy of Arts and Sciences

Paul H Rubin is Samuel Candler Dobbs Professor of Economics at Emory University His main area

of research is law and economics

F M Scherer is Aetna Professor Emeritus at the John F Kennedy School of Government, Harvard

University His research specialties are industrial economics and the economics of technologicalchange

Carl J Schramm is President and CEO at the Kauffmann Foundation.

David J Teece holds the Thomas W Tusher chair in Global Business and is Director at the Center

for Global Strategy and Governance at Haas School of Business, University of California, Berkeley

Philip R Tomlinson is Lecturer in Economics in the School of Management at the University of Bath.

His research interests and publications lie predominantly in the area of industrial development andpolitical economy He is a member of the European Union Network for Industrial Policy

Bernard Yeung is Stephen Riady Distinguished Professor and Dean at NUS Business School,

National University of Singapore

INTRODUCTION: THE GOOD, THE BAD, AND THE

UGLY

DENNIS C MUELLER

I have chosen the title of Sergio Leone’s classic spaghetti Western as the subtitle for this introductoryessay because it nicely captures the range of views of capitalism contained in this volume One might

expect that a Handbook of Capitalism would focus only on its merits—why describe at length a set of

institutions that is essentially bad? This volume does contain several chapters that highlight thepositive side of capitalism Most (if not all) contributors to this volume probably believe, as I do, thatcapitalism’s virtues greatly outweigh its faults The high standards of living observed in Europe,North America, and other highly developed parts of the world would be impossible withoutexploiting the great potential of capitalistic production But there is a darker side to capitalism, andthis volume contains several contributions that explore some of the negative consequences or, perhaps

better, side effects of capitalism.

Although it is customary to speak of “capitalism” as if it were a well-defined set of institutionsthat either exists or does not exist in a given country at a particular point in time, capitalisticinstitutions actually come in many varieties and have evolved in different ways in different countries.Chapters by Frieden, Beck, Roe, Coffee, and Odagiri describe the great variety of capitalisticsystems that exist and how they evolved I briefly describe the essentials of capitalism in the nextsection I then proceed to take up its good, bad, and ugly characteristics Some conclusions are drawn

in the final section.1

W HAT I S C APITALISM ?

The defining feature of capitalism is that the means of production—capitalistic production—are in thehands of private individuals and firms Implicit in the notion of a capitalist system, however, is alsothe existence of a market economy—a “free market” economy A planned, socialist economy couldengage in capital-intensive production—as the Soviet Union did—and we would not think of it as acapitalist system Even if the capital was nominally held by private parties, it would not be a truecapitalist system if the state intervened to set prices, restrict the flow of finance, and so on Indeed,when economists extol the virtues of capitalism, they typically dwell on the efficient allocation ofresources that market competition is thought to produce, rather than the benefits from capitalistproduction as such If traders are endowed with initial stocks of goods, Walrasian markets canproduce Pareto optimal reallocations of these stocks “Invisible hand” stories can be told withouthaving to invoke capitalistic production

The vast wealth of the rich countries of the world did not arise, however, because Walrasian

markets efficiently reallocated existing stocks of goods Starting around the time Adam Smith wrote

Wealth of Nations , the Industrial Revolution began to enfold (see Frieden’s chapter) The Industrial

Revolution changed both the way goods were produced and the nature of the goods themselves.Production processes became more capital-intensive and this necessitated the development ofinstitutions to accumulate and allocate capital Building on the advances of the scientific revolution ofthe seventeenth and eighteenth centuries, entrepreneurs during the Industrial Revolution introducednew products and new production techniques The innovations creating these new products andproduction techniques introduced great uncertainty into the capitalist production process and gaverise for the need for contracts and institutions to enforce them

Contracts exist due to uncertainty In a spot market transaction, say, the exchange of an apple for

an orange, two traders will not bother to write a contract (I promise to give you my orange …), nor

does it add insight into the nature of the transaction to say that an implicit contract exists Each trader

knows what he is giving up and what he gets in return There is no uncertainty However, when atransaction takes place over a longer period of time (I promise to buy a train carload of apples fromyou in one year), uncertainty enters into the transaction (the spot price of apples in one year), and thetraders might well choose to write a contract specifying the terms of the transaction to ensure againstunknown contingencies that may arise because of the long-run nature of the exchange, or to ensureagainst the opportunistic behavior of the other party in the transaction If they do not write an explicitcontract, there will still be some sort of implicit contract underlying the transaction (I promise to buy

a train carload of apples from you in one year at the spot market price at that time.) Thus, theuncertainty inherent in capitalistic production makes contracts an important institution underpinningthe system (see chapter by Goldberg)

If an entrepreneur is going to invest time and money to develop a new product, she must knowthat she can sell it at a sufficiently high price to recoup her investment and earn a profit In capitalistsystems, this assurance is typically afforded through the grant of a patent or trademark—a form of

property right to the new product The product or the innovative ideas behind it belong to the

entrepreneur, at least for a limited period Property rights are thus a second, key institution underlyingcapitalism that help induce entrepreneurs to make the investments and take the risks needed forsuccessful capitalist development (see chapter by Rubin and Klumpp)

As the scale of production expanded over the nineteenth century, the accumulated wealth of richfamilies no longer sufficed to finance all of the profitable large-scale investments that appeared.Alternative institutions were needed to accumulate savings and transfer them to the entrepreneurs whocould profitably invest them The rise of modern capitalism thus brought with it the rise of largebanks, and the development of organized stock and bond markets The role of financial institutions incapitalist systems is discussed by Thorsten Beck

As the Industrial Revolution unfolded, the scale of production increased, and new organizationalstructures had to be created The large corporation began to emerge Although not a logical necessityfor a capitalist system, large corporations have become a salient feature in virtually every rich,developed capitalist country Indeed, so great is the role played by large corporations in modern

capitalist systems, it is more revealing to refer to them as corporate capitalism instead of just

capitalism.

The modern corporation represents a kind of economy within an economy with its own internalcapital market, internal labor market, and system of incentives to induce good performance Tounderstand how capitalism works today, one must understand the internal workings of the largecorporation (see chapter by Teece)

Although large corporations exist in all capitalist economies today, there are importantdifferences in ownership and control structures across countries In some countries, founding familiescontinue to control companies decades or even centuries after their creation In other countries,control lies mainly with professional managers, and ownership is in the hands of dispersed individualand institutional shareholders (see discussion in chapters by Coffee and Odagiri) An ongoing debateexists in the profession to try to account for the conspicuous differences in capitalist systems acrossthe world Are these differences due to differences in the politics and ideologies of differentcountries, differences in legal institutions, or some other idiosyncratic events specific to a particularcountry? The chapters by Frieden, Beck, Roe, Coffee, and Odagiri describe and account for thesedifferences.

Thus, the answer to the question posed in the title of this section—what is capitalism?—is that it

is not a single institution but a set of institutions—private ownership of the means of production,competitive product and factor markets, large banks and financial markets, contracts, property rightsand judicial institutions to enforce them, and large corporations Although all capitalist systems havethese institutions in common, there are also many important differences across countries in the formsthese institutions take and how they are combined

T HE G OOD

Since the agricultural revolution during the Neolithic Age some 10,000 years ago, nearly all societieshave consisted of small, relatively well-off elites ruling and often exploiting the rest of society,whose members toiled long hours to produce just enough to survive For the first time in history,today countries in the rich, capitalist countries of the West do not confront the problem of peoplelacking food and dying too young but of being overweight and living too long

In the eighteenth century it took several months to cross the Atlantic Ocean on a trip fraught withdanger At the beginning of the twentieth century, it still took the better part of a week to cross theAtlantic with the possibility of a collision with an iceberg still creating some risk Today, the triptakes a matter of hours and involves almost no risk Indeed, a trip to the moon takes less time than atransatlantic crossing a century ago, and by the end of the twenty-first century, private citizens arelikely to find a trip to the moon about as arduous as a transatlantic flight is today For thosedisinclined to fly, the Internet provides instant face-to-face communication between Buffalo andBerlin

The growth in incomes afforded by capitalism has made it possible for all citizens to acquire aneducation, not just a small elite With mass education, rule by the masses becomes possible The term

“the West” today conjures up the image of both capitalism and democracy

The term “democracy,” in turn, carries with it the idea of individual freedom Individualfreedom requires more, however, than just the absence of slavery An individual who must worktwelve hours a day, seven days a week just to earn enough to survive cannot be said to be truly free.The rising incomes produced by capitalism have enabled work weeks to be shortened and vacationslengthened The automobile, airplane, and mass transit have reduced transportation costs Homeappliances have freed people from the drudgery of housework Most important for women, theinvention of the birth control pill made family planning a practical reality and freed them to acquireeducations and pursue careers Individuals have never had as much freedom to choose their careersand lifestyles as they have today in capitalist countries If one seeks proof for this, one need only look

at the plight of individuals in the many countries of Africa, Asia, and South America where capitalismdoes not exist or exists in only a rudimentary, state-controlled form Or one can look at the plight ofindividuals in former members of the Soviet Union, which are technically no longer communist butalso are not truly free and capitalistic.

At the heart of any successful capitalist system are free and competitive markets If one sought asingle explanation for why countries that were once part of the Soviet Union continue to performpoorly after communism’s official demise, it is because their authoritarian governments continue tointerfere with the workings of market institutions Much research in the laboratory and real-worldmarkets demonstrates that they do function, for the most part, as our textbooks say they do AdamSmith did not exaggerate The long queues of people waiting to buy shoddy products so oftenobserved in communist countries do not appear when markets are allowed to function freely

Capitalism’s virtues are not restricted to achieving a Pareto optimal allocation of an initial stock

of apples and oranges, however Capitalism’s triumph over Soviet-style socialism was not simplybecause capitalist economies got the prices right Western capitalism triumphed because it was vastlysuperior to Soviet-style social planning in producing new and superior products and productiontechniques The dramatically higher standards of living achieved in Western capitalist countries arosebecause of the steady increases in productivity that brought prices down over time and the steadystream of new products reaching the market that expanded consumers’ range of choices The formerSoviet Union countries continue to lag the West because they have failed to establish secure propertyrights and the other institutions of capitalism that give would-be entrepreneurs incentives to innovate

Once we recognize the importance of innovations for the success of capitalism, we see that it isnot Adam Smith’s account of the wealth of a nation but Joseph Schumpeter’s that explains the greatincrease in living standards over the last two centuries in the West Competition remains at the heart

of a capitalist system, but it is competition from the new product, the new production technique, andthe new organizational structure that drives economic progress and growth (see chapters by Schererand Baumol, Litan, and Schramm) To understand how capitalism functions, and why it produces theincreases in wealth we associate with it, it must be viewed as a dynamic process Changes in pricescan lead to Pareto improvements as consumers and producers move toward the productionpossibilities’ frontier, but shifts in the frontier brought about by innovations have the greatest impacts

on individual well-being

T HE B AD

The most obvious negative feature of capitalism is that it can produce private monopolies that restrictoutput and thereby harm consumers The chapter by Cowling and Tomlinson describes the manypossible adverse consequences of “monopoly capitalism.” Thus, monopoly in a capitalist system can

be seen as a double-edged sword The lure of monopoly and the rents that accompany it are whatdrive individuals to become entrepreneurs and introduce the innovations from which we all benefit.Those who succeed to become monopolists, however, have the incentive to prolong their monopolies

as long as possible to the detriment of social welfare Without Schumpeter’s perennial gale ofcreative destruction, capitalism can atrophy into the kind of “oligarchic capitalism” described byBaumol, Litan, and Schramm, where only an oligarchic elite benefits from capitalist production

In addition to the static welfare losses produced by monopoly in the form of high prices and

smaller than optimal outputs, there are the dynamic welfare losses that arise from the rent-seeking

activities of monopolists and those who aspire to become monopolists Without economic rents therecannot be rent seekers The great success of entrepreneurs innovating and creating monopoly rentsopens the door for others to attempt to seize those rents For the individual who seeks to become rich,

it is a matter of indifference if she does so by creating a large rent through the introduction of a new product or by acquiring an existing rent As Baumol, Litan, and Schramm point out, patents are an

important institution for protecting the monopoly rents generated by an innovation, and therebyprovide entrepreneurs with incentives to innovate But once granted, they produce additionalincentives for the innovator’s competitors to try to break or circumvent the patents Thus, dominantfirms that invest heavily in R&D, like Intel, Microsoft, Pfizer, and Merck, must employ armies oflawyers to protect the rents that their many patents generate, and their competitors match theirexpenditures with lawyer armies of their own These rent-seeking outlays—vast as they are—generate little or no benefits for consumers

A similar observation can be made with respect to advertising Advertising the introduction of anew product increases social welfare, because the benefits from consuming the new product cannot

be obtained if one does not know of its existence Much advertising is of existing products, however,and is undertaken to protect the rents associated with a particular brand or to capture the rents of arival’s brand No new consumer surplus is created, no social benefits are generated

An innovative idea—a formula for a new drug, a blueprint for a new production technique—isessentially a piece of information Patents give their holders property rights to these pieces ofinformation The peculiar properties of information give rise to all sorts of rent-seeking activities

Jack Hirshleifer (1971), in an important and neglected article, pointed out that investments toacquire information had social value only when they lead to individual decisions that improve theallocation of resources Launching satellites to gather weather information has social value if theinformation leads to better decisions by farmers as to when to plant and harvest crops Gatheringinformation about the extent of damage to this year’s orange crop caused by an unexpected severefrost might be highly profitable to someone wishing to speculate on orange futures before the extent ofdamage became widely known, but it would have no impact on the size of this year’s harvest andlittle or no social value

Some 95 percent of the shares traded on the New York Stock Exchange are not new issues Thefunds spent buying them do not flow into new investment, but go to the previous owners of the shares.Large gains from trading can be made from knowing which share prices are likely to rise or fall, andlarge sums are invested generating and acquiring information to predict price movements Althoughthis information may make the capital market somewhat more efficient and lower corporate costs ofcapital a bit, or improve the market for corporate control, the bulk of it simply results in private gains

to those who have good information, which are matched by the private losses to those with poorinformation Much of the information gathering surrounding financial markets is a form of rentseeking This fact helps explain the empirical results discussed by Beck in his chapter on financialinstitutions In poor or middle-income countries large financial markets facilitate the flow of funds tofirms making investments and innovations, thereby promoting economic growth The link between thesize of the financial sector and economic growth weakens—or even reverses—once countriesbecome rich and reach the technological frontier Now rent seeking in financial markets can lead togreat private gains but have little impact on economic growth Growth is actually harmed to the extentthat talented risk takers are drawn into the financial sector to engage in rent transfers, rather thanstarting businesses and engaging in rent creation

When Joseph Schumpeter (1934, pp 93–94) described the goals of the entrepreneur in his

classic treatise on economic development, he depicted the entrepreneur as an empire builder first andforemost At the time when he wrote—the beginning of the twentieth century—the only way that anentrepreneur could command an empire was to build one.2 This was just as true in the United States,where the Carnegies and Rockefellers were building empires, as it was in Europe, where Schumpeterobserved the Krupps and Thyssens building empires A young man wishing to command an empiretoday has two options: he can follow the paths of Carnegie and Krupp and build a corporate empirefrom scratch, or he can try to work his way to the top of one of the many existing corporate empires inthe United States, Europe, and the other developed countries of the world The risks involved inbuilding an empire are far greater than those in trying to mount an existing one—even if one does notmake it all the way to the top, one can expect a comfortable income—and thus most people who wish

to command an empire today choose to join existing corporate empires rather than to create new ones

If we define a rent as the difference between a person’s income with his present employer andhis opportunity costs with a different employer, then LeBron James’s $40 million salary with theCleveland Cavaliers in 2009 probably contained no rents, as many NBA teams would match thisfigure to acquire his talents If, however, we define a rent as the difference between a person’sincome in his present occupation and his opportunity costs in a different occupation, then most of the

$40 million salary is an economic rent Thousands (if not millions) of young boys in the United Statesspend countless hours playing basketball in the hopes of developing the talents that would make themthe next LeBron James Only a tiny fraction will get to play professional basketball, only one or twowill have the success of James The hours spent playing basketball by those who do not succeed—treated as an investment—go wasted Society and the boys themselves would be much better off ifthey had spent the time studying algebra and chemistry

Something similar happens in the world of business At the top of the Forbes list of CEO

incomes in 2009 was Oracle’s Lawrence J Ellison, with a total compensation of $557 million.Although Ellison would no doubt have earned a sizable income if he had chosen another profession—say, law or medicine—much of his more than half billion dollar income must be considered aneconomic rent from being a business manager As with basketball, thousands if not millions of youngmen, and in this case also women, in the United States spend countless hours getting MBAs and trying

to work their way up corporate ladders in the hopes of becoming the next Ellison

If the procedures corporations use to select and promote their personnel function well, the mosttalented managers will reach the tops of the most important companies The performance of thesecompanies is no doubt better than it would be if a less competitive process with smaller rewards forsuccess existed, just as the quality of basketball in the NBA is undoubtedly better with top salaries of

$40 million than it would be with top salaries of $4 million But the social gains are unlikely toexceed the rent-seeking costs The United States would almost certainly be better off if more youngpeople went to work for small, new businesses or started their own businesses, rather than enteringlarge companies in the hopes of rising to the top

Monopoly and the rents it creates are often referred to as market imperfections in economic

textbooks Such market imperfections can be regarded as part of a much wider class of problems in

market economies that fall under the heading of market failures Although monopolies are intended

consequences of individual actions, many other market failures like negative externalities areunintended consequences of the pursuit of profit Richard Nelson’s chapter makes clear that these

“side effects” of the market process cannot be ignored when considering the performance of capitalistsystems

T HE U GLY

Rents are an inevitable part of capitalistic production in a world in which resource movements are

not costless and instantaneous, that is to say, in the real world Rent seeking, therefore, is a central

feature of every capitalist system, and the more successful the system is at generating rents, the moreresources are wasted in rent-seeking activities Although this seems quite obvious today, some fortyyears ago the concept of rent seeking was unknown.3 Even today, although all economists know whatrent seeking is, often when they discuss broad issues, like the virtues of capitalism, they ignore rentseeking and the costs that come with it

The same can be said of the principal agent problem Principal agent problems abound (see thechapter by Morck and Yeung) We enter into one every time we go to a dentist, have our car repaired,

or enter a taxi The greater the division of labor, the more principal agent problems we confront Yetdespite their ubiquity, the term “principal agent problem,” like rent seeking, is a scant forty yearsold.4 The “problem,” however, was recognized much earlier The separation of ownership from

control in U.S corporations was described and documented by Berle and Means nearly eighty years

ago in their classic Modern Corporation and Private Property (1932, 1968) In this book, Berle and

Means identified the most serious of all principal agent problems—at least in capitalist systems likethe United States where shareholdings are widely dispersed—that between the stockholders asprincipals, who want to have their wealth maximized, and their agent-managers, who have their owngoals to pursue

Despite the attention that the Berle and Means book received, the implications of the existence ofthis form of principal agent problem in large corporations did not affect the way economists analyzedcorporate and market behavior for many years after the book’s publication Indeed, at a conferenceheld at the University of Chicago ostensibly to commemorate the fiftieth anniversary of the book’spublication, most participants presented papers claiming that the problem did not exist or was of littleimportance.5 How can one explain such neglect of a problem that today seems so obvious andimportant? Perhaps the answer lies with the fact that Berle and Means were “outsiders” to theeconomic profession Indeed, Berle was not even an economist, and Means worked in the Rooseveltadministration at first Means even had the audacity in 1935 to publish a paper that attempted toexplain the “stickiness” of prices in the downward direction during the Great Depression by claimingthat managers of large corporations did not set prices by equating marginal revenue to marginal cost

Today, it is difficult to ignore the existence of a major principal agent problem betweenmanagers and shareholders in large, dispersed ownership corporations—although a surprisingnumber of economists still do What is it that managers pursue with the great amount of discretion thatthe separation of ownership and control gives them? To this question, economists have given manyanswers Perhaps the most obvious goal of all, at least to an economist, is money Managers use theirfreedom to pursue their own interests by increasing their wealth at the shareholders’ expense Berleand Means were concerned that managers would simply steal or embezzle money from theshareholders Many examples of this happening came to light during the first few years of the GreatDepression, and the recent examples of Enron and WorldCom reveal that some managers still dosuccumb to this temptation The more frequent accusation, however, is that managers greatly overpaythemselves Someone who earned the minimum hourly wage of $7.25 in 2009 and worked forty hours

a week for fifty-two weeks would have earned $15,080 If Lawrence J Ellison put in the samenumber of hours of work, he earned more than this minimum-wage worker in the first three minutes

and sixteen seconds that he worked Is Ellison’s marginal product really that much higher than theminimum-wage worker’s?

As Conyon describes in his chapter, the literature offers two sets of answers to this question.One group of scholars emphasizes the principal agent problem in large corporations and claims thatthis effectively allows managers to select their own compensation packages It is thus unsurprisingthat these compensation packages seem overly generous

The other stream of the managerial compensation literature sees the high salaries of managers as

a consequence of intense compensation for managerial talent Although managerial compensation hasgrown rapidly over the past quarter century, so have the sales and market values of companies Thegrowth in managerial compensation has simply kept pace with the growth in firm valuations

These are two, quite divergent views of what has been happening with respect to managerialcompensation Over one fact, both sides agree, however—the single best predictor of managerialcompensation is some measure of company size Company size is a far better predictor of managerialcompensation than measures of company performance like profitability and returns to shareholdersthat one might think should be closely linked to managerial compensation

The close association between company size and managerial compensation does not dispose ofthe principal agent problem as far as managerial compensation is concerned, however Earlycontributions to the managerial discretion literature by Baumol (1959, 1967) and Marris (1964)claimed that it was size or growth in size that managers maximized, not profits or shareholders’wealth One justification for this claim was the close association between size and compensation.6

A manager who wishes her firm to grow fast has several options One is to invest heavily inR&D, innovate, and enjoy the rapid growth that innovations often generate Microsoft might beregarded as a classic example of such a Schumpeterian firm After twenty years it was the dominantfirm in computer software and its founder, Bill Gates, was the richest man in the world Such growththrough innovation takes time, however, and can carry enormous risks A quicker and surer path togrowth is through mergers General Electric did not attain its current size merely by exploiting the

potential in Edison’s light bulb invention Most Fortune 500 companies owe a considerable fraction

of their size to mergers

Whether managers choose to grow internally by innovating or through mergers should be amatter of societal indifference, if both strategies generate wealth On this question the mergerliterature—like the managerial compensation literature—divides into two streams, and the streamsare nearly parallel in their assumptions and conclusions (see my chapter) One stream in the mergerliterature assumes that managers maximize shareholder wealth, markets work efficiently, including

“the market for corporate control,” and thus that mergers generate wealth and improve the allocation

of resources The other assumes the existence of agency problems, that managers seek to advancetheir own personal welfare, and that they may undertake mergers that destroy shareholder wealth

The assumption that managers maximize shareholder wealth when they undertake mergers isdifficult to reconcile with the overwhelming evidence that the average merger generates little or nogains to the acquiring companies’ shareholders at the merger announcements and large and significantlosses after two to three years Some mergers definitely do benefit the shareholders of acquiringcompanies and improve the allocation of resources, but this cannot be said for the average merger

The preponderance of mergers in the United States and United Kingdom have taken place duringstock market booms This is an empirical fact that researchers on both sides of the merger issue agree

on It is also an empirical regularity that is difficult to reconcile with many theories of mergers thatassume wealth-creating motives Wealth-creating opportunities, like achieving economies of scale

and scope, should be attractive even when stock prices are behaving normally An agency explanationfor the link between share prices and merger activity would be that managers prefer to announcemergers that are likely to destroy shareholder wealth at times when optimism in the stock market ishigh In such periods of “irrational exuberance,” when shareholders are looking for reasons to buyshares, announcements of mergers, with accompanying predictions of economies of scale and scopeand undefined synergies, are more likely to be greeted favorably by investors than when made inperiods of more sober stock market sentiment This agency explanation for the link between shareprices and merger activity also helps account for the more favorable performance of acquirers’ shareprices around merger announcements than in the years that follow.

Thus, to understand mergers one must also understand stock market booms As Malkiel’s chaptershows, asset bubbles existed even before the Industrial Revolution Perennial gales of destruction ofasset values are another common feature of the economic landscape, along with Schumpeter’s galesproduced by innovative activity Although the assets subject to bubbles have varied widely from tulipbulbs in Holland to condominiums in Japan, the psychology underlying bubbles seems to beremarkably the same Prices of an asset begin to rise producing an expectation that they will risefurther This expectation proves to be self-fulfilling The gains made by early speculators feed theiroptimism and lead them to buy still more of the inflating assets Prices continue to rise until they arefar above their historical values and above any possible calculation of true, underlying economicvalue As they rise higher and higher, more and more traders realize that the bubble is unsustainable.Once these traders begin to sell, prices begin to fall and the bubble breaks

Each of the bubbles in share prices in the United States dating back to the end of the nineteenthcentury has been accompanied by a merger wave The stock market boom and merger wave of the late1920s was followed by a “lost decade”—the Great Depression The stock market boom and mergerwave of the late 1960s was followed by another lost decade, and at the time of this writing (2010),the decade of buoyant share prices and surging merger activity that began in the mid-1990s seemslikely to be followed by yet another lost decade The recurring asset bubbles and merger waves thatseem a part of capitalism inflict heavy economic losses on society

C ONCLUSIONS

At the end of the Korean War, both North and South Korea were poor countries with devastatedeconomies South Korea chose to develop a capitalist system, and North Korea followed the path ofcommunism Today, South Korea has a GDP per capita of over $27,000, comparable to that of NewZealand, and North Korea remains mired in poverty, scarcely able to feed its population.7 A morevivid example of the advantages of capitalism and freedom extolled by Friedman (1962) is difficult

to find

I have devoted more space in this introduction to problems associated with capitalism than to itsvirtues because the advantages of capitalism seem so obvious, as the two Koreas demonstrate EvenChina, one of the last surviving communist countries, has relied heavily on capitalist institutions tofoster its “economic miracle” over the past two decades

Capitalism is at its best when individual self-interest is channeled into the production of goodsand services and innovative activity To undertake the huge risks that surround the innovation process,entrepreneurs must possess great optimism about their ability to make decisions Although many

entrepreneurs fail, the innovations generated by the few who succeed lead to the great advances inwealth that we associate with the developed, capitalist countries of the world Once the pioneersshow the way, the pursuit of wealth leads imitators to follow, generating Schumpeter’s gale ofcreative destruction, and it in turn leads to falling prices and still more benefits to consumers.

The seamy side of capitalism is largely the reverse of its attractive side The creation of rentsthrough the introduction of new products and production processes is the driving force behindcapitalist development, but once they are created they become the target of rent seekers who devotetheir efforts to capturing existing rents rather than creating new ones Asset bubbles are fed by thegreat optimism of traders in their ability to make decisions In their pursuit of growth, managersexploit the (over)optimism in equity markets during stock market booms to undertake wealth-destroying acquisitions Indeed, so contagious is optimism during stock market booms that themanagers making acquisitions may overestimate their ability to make decisions and actually believetheir acquisitions will create wealth.8 Thus, the desire to create empires, the pursuit of great wealth,and the optimism needed to fuel entrepreneurship and innovation, when channeled into rent seeking,growth through acquisitions, and asset speculation, can undermine the efficiency of a capitalistsystem

The policy implications are obvious—channel the self-interest of potential entrepreneurs,managers, investors, and speculators into creating wealth rather than transferring or destroying it Theexact form such policies should take, however, is far from obvious Should original patents be betterprotected from challenges by followers, or should patents be done away with? Should the stateintervene in setting managerial salaries? While markets can fail in many ways, the public choiceliterature is replete with examples of state failures Some of the essays in this volume offerconstructive suggestions for how to improve the functioning of capitalist systems, but there are nosilver bullets in this area Fortunately, the wealth generated by the productive side of capitalismgenerally is great enough to sustain the wealth destruction that transpires on its seamy side

N OTES

1 Edmund Phelps’s chapter arrived after I had completed a first draft of this introduction Thereare some similarities in organization and content between our work, but the differences aregreat enough that I decided to leave this introduction largely as it was

2. The German edition of The Theory of Economic Development first appeared in 1911 The

1934 date in the text is for the English translation

3 Gordon Tullock (1967) was the first to discuss rent-seeking activities The term “rentseeking” was first used by Anne Krueger (1974)

4 To my knowledge, Ross (1973) introduced the term

5. See the special issue of the Journal of Law and Economics (vol 26, June 1983) devoted to

the conference Douglass North’s contribution was a notable exception to the patterndescribed in the text

6 See evidence surveyed by Marris (1964, chapter 2)

7. The CIA estimates North Korea’s GDP per capita to be $1,800 CIA, The World Factbook,

January 28, 2010

8 To explain why acquiring shareholders lose as a result of mergers, Roll (1986) advanced the

hypothesis that acquiring companies’ managers often suffer from hubris They know that theaverage merger is unsuccessful but believe that they are better than the average manager.Although Roll did not put forward his hypothesis as an explanation for merger waves, the kind

of hubris he describes is particularly likely to grip managers during stock market booms,when their companies’ share prices are rising rapidly

Friedman, Milton Capitalism and Freedom Chicago: University of Chiago Press, 1962.

Hirshleifer, Jack “The Private and Social Value of Information and the Reward to Incentive

Activity.” American Economic Review 61 (Sept 1971): 561–574.

Krueger, Anne O “The Political Economy of the Rent-Seeking Society.” American Economic

Review 64 (June 1974): 291–303; reprinted in Toward a Theory of the Rent-Seeking Society, ed James M Buchanan, Robert D Tollison, and Gordon Tullock, 51–70 College

Station: Texas A&M Press, 1980

Marris, Robin The Economic Theory of Managerial Capitalism Glencoe, Ill.: Free Press,

1964

North, Douglass C “ ‘The Literature of Economics: The Case of Berle and Means.’ Comment on

Stigler and Friedland.” Journal of Law and Economics 26 (June 1983): 269–271.

Roll, Richard “The Hubris Hypothesis of Corporate Takeovers.” Journal of Business 59 (April

1986): 197–216

Ross, Stephen A “The Economic Theory of Agency: The Principal’s Problem.” American

Economic Review 63 (May 1973): 134–139.

Schumpeter, Joseph A The Theory of Economic Development 1911; Cambridge, Mass.:

Harvard University Press, 1934

Tullock, Gordon “The Welfare Costs of Tariffs, Monopolies and Theft.” Western Economic

Journal 5 (June 1967): 224–32; reprinted in Toward a Theory of the Rent-Seeking Society, ed James M Buchanan, Robert D Tollison, and Gordon Tullock, 39–50 College

Station: Texas A&M Press, 1980

PART I ORIGINS

CHAPTER 1 THE MODERN CAPITALIST WORLD ECONOMY: A

HISTORICAL OVERVIEW

JEFFRY A FRIEDEN

CAPITALIST economic activities are of very long standing—some would say they were present inproliferation during Roman times.1 By the late medieval and early modern period, large areas ofWestern Europe had thriving, relatively free markets for labor and capital, both in the city and in thecountryside We can most fruitfully and confidently speak of the full flowering of modern capitalismonce it became a truly international economic order That epoch evolved over the course of thesixteenth, seventeenth, and eighteenth centuries, as capitalism expanded from a limited WesternEuropean base to affect much of the world, from the Americas to East Asia

A M ERCANTILIST W ORLD E CONOMY

Market economies flourished in many parts of Europe during the high and late Middle Ages, mostprominently in Italian commercial and manufacturing centers such as Genoa, Venice, and Tuscany.Although they relied heavily on long-distance trade, these islands of capitalism had little structuraleconomic impact on the rest of the world But after the 1450s, the Ottoman Empire’s control of theEastern Mediterranean drove Europeans out into the Atlantic, and eventually around the world, insearch of trade routes Western Europeans’ recognition of the economic potential of the New Worldand of more consistent interaction with Africa and Asia opened a new era

For nearly four centuries, from the mid-1400s to the mid-1800s, the rest of the world was drawninto an economic and political order dominated by European capitalism This order was organizedaround the overseas colonial empires of the Atlantic powers: first Spain and Portugal, then theNetherlands, England, and France This was the first true international economy, and it wascontrolled in a very particular manner by its European founders The economic system they built hascome to be known as mercantilism

Mercantilist ordering principles defined the international capitalist economy for several hundredyears Although there was variation among the principal mercantilist powers, the system’s mainfeatures were common to all First and foremost, mercantilism depended on substantial governmentinvolvement in the economy These were, after all, colonial systems, and military might underpinnedthe predominance of the colonial powers over their possessions But that was not all Mercantilistgovernments considered their economic policies to be part and parcel of broader national goals,especially in the continuing struggle for diplomatic and military supremacy Mercantilism enriched

the country and the Crown, which then used those riches to build up military force “Wealth ispower,” wrote English philosopher Thomas Hobbes, “and power is wealth.” One of his fellowmercantilist thinkers drew the connections: “Foreign trade produces riches, riches power, powerpreserves our trade and religion.”2

The mercantilist economic order relied on systematic government intervention in the economy,particularly in international economic transactions Although there was variation among countries andover time, core mercantilist goals and policies were similar Mercantilist governments tried tostimulate demand for domestic manufactures and for such national commercial and financial services

as shipping and trade They did this, typically, by requiring their colonies to sell certain goods only tothe mother country (the “metropole”) and buy certain other goods only from the mother country.Restrictions on trade turned the terms of trade against the colonies: prices of colonial exports weredepressed, while prices of colonial imports were elevated This, of course, benefited metropolitanproducers, who could purchase their inputs (raw materials, agricultural products) at artificially lowprices and sell their output (manufactures) at artificially high prices Virginia tobacco farmers had tosell their leaf to London, although Amsterdam would have paid more; they had to buy their cigarsfrom London, although Amsterdam would have charged less The rents created this way went toenrich the manufacturers and “merchant princes,” whose alliance with the Crown characterized themercantilist political economy

Mercantilist governments also required many international economic transactions to be carriedout by their preferred, national agents: shipping, insurance, finance, wholesale trade In some cases,trade had to be channeled through certain favored ports Like import and export restrictions, thisprovided rents to the privileged The colonial governments also endeavored to discover and exploitprecious metals The Crown usually took (or taxed very heavily) the gold and silver discovered in thecolonies Mercantilist governments typically chartered monopolistic enterprises to which theydelegated both economic and administrative functions in the colonies, such as the Hudson’s BayCompany and the Dutch East India Company

Mercantilist policies achieved several interrelated goals They provided revenue for thegovernment This might come directly from precious metals and other forms of tribute or indirectlyfrom the revenue provided by those enriched by the policy This was one sense in which mercantilisteconomic policies supported the broader diplomatic and military goals of the government: they madeavailable the wherewithal to sustain and increase national power Mercantilist policies also aimedexplicitly at encouraging early manufacturing, seen as central to modern economic and militaryadvance.3 And the restraints on trade and monopolistic charters cemented ties between thegovernment and its powerful supporters in business

The political economy of mercantilism was largely based on an implicit or explicit alliancebetween the government—the Crown, except in the Dutch Republic—on the one hand, and themerchants, manufacturers, and investors that carried out the bulk of economic interactions with thecolonies on the other.4 The character of this alliance varied from country to country In theNetherlands, the mercantile classes effectively and directly controlled the state; in the other colonialpowers, the government had interests of its own, which sometimes conflicted with those of itsbusiness allies The Spanish Crown, for example, was particularly concerned with consolidating itscontrol over the country, which was only fully freed of Muslim rule in 1492, and in which there werepowerful regional noblemen This made the Spanish Crown more insistent on centralizing control andrevenue and less willing to encourage the rise of powerful private actors than many other mercantilistrulers

Mercantilist policies benefited the favored metropolitan businesses, at the expense of thecolonies (and consumers) To be sure, some colonial subjects valued membership in a powerfulempire, especially inasmuch as the empire protected them from others While many citizens of GreatBritain’s North American colonies chafed at mercantilist restrictions on their trade, many othersappreciated the security British naval and military power provided.

The mercantilist era’s main characteristics highlight enduring features of modern capitalisteconomies The first is an ambivalent relationship with the world economy To be sure, the leadingcolonial powers were heavily oriented toward engagement in the international economy and eager totake advantage of what the rest of the world economy had to offer At the same time, mercantilistpolicies were highly nationalistic and strongly protected the home market and national producersfrom foreign competition This tension, between the desire to take advantage of internationaleconomic opportunities, on the one hand, and the fear of harm from foreign competition, on the other,

is a recurring theme in capitalist attitudes toward the world economy The mercantilist powers dealtwith the issue by aggressively expanding their access to foreign markets, but jealously guarding andprotecting the markets they conquered within their colonial empires

A second feature of the mercantilist experience was the tension between state and markets In themercantilist period, as at other times, market actors wanted economic freedom, and governmentswanted the prosperity markets could provide Indeed, markets were almost certainly much betterdeveloped and much freer in this era than they had been in the previous medieval centuries At thesame time, mercantilist governments were aggressive in their intervention in the economy To someextent this reflected real or imagined demands of national security and military power, in an attempt

to harness economic dynamism to national goals To some extent it reflected the interests of powerfuleconomic interest groups, which were enriched by state-enforced monopolies, state controls on trade,and the backing of their governments The result was a mix of state intervention and marketdevelopment—not always harmonious

Indeed, these two dimensions have been at issue throughout the history of capitalism The first isthe international-national dimension: the conflicting desire for integration with and insulation from theworld economy The second is the state-market dimension: the conflicting desire for governmentinvolvement in markets and market freedom from government Over time, both countries and theworld in general have oscillated between periods of greater and lesser economic openness andbetween periods of greater and lesser government intervention in the economy

Mercantilism reflected the economic and political realities of its era Western Europeaneconomies had advanced enough beyond those in the rest of the world, both in technology and inorganization, that their predominance was largely unchallenged Meanwhile, previously unimaginableoverseas economic prospects had opened up, a whole world of resources and markets that could betapped and, in most cases, controlled This provided the incentive, to rulers and capitalists alike, toassert themselves wherever possible At the same time as the mercantilist powers were subjugatingvast areas to their colonial control, they engaged in continuing conflicts with one another forsupremacy This gave them powerful motivations to use their colonies to enhance their military mightand to use their military might to amass more colonies Domestically and internationally, at home andabroad, the mercantilist systems generally reflected a mutually rewarding partnership between rulersand capitalists, enriching both and drawing most of the world into their orbit

T HE E ND OF M ERCANTILISM

A combination of political and economic developments began to erode the mercantilist system.Politically, one of the attractions of mercantilist policies had been their connection to the struggle fordiplomatic supremacy: reserving access to colonies to the home country and restricting it to othersserved to help the government amass resources for military purposes and to deny resources to real orpotential enemies But in 1815, a British-led alliance defeated Napoleon at Waterloo and effectivelyended three centuries of warfare among the Atlantic powers With British maritime supremacyensured, and the Continent largely stable, the military arguments for mercantile colonialism faded.

Domestic political trends also undermined the mercantilist system Throughout Western Europe,autocratic dynastic rule came under challenge, largely from the rising business and middle classes.Although political reform was slow, and certainly did not result in anything we would recognize asdemocratic, it did loosen the exclusive grip on power of some previously favored groups Amongthese were the monopolistic enterprises created and favored by mercantilist policy, whosepreferential position was increasingly resented by more modern entrepreneurs in industry, trade, andfinance As the foreign policy arguments for mercantilism faded, so did the domestic politicalalliances underpinning it

Economic trends also eroded the previous political economy Most important was the rise ofmodern industry Manufacturing in the earlier era, though certainly an advance over the medievalnorm, was on a small scale, often based on cottage industry Over the course of the eighteenth andearly nineteenth centuries, manufacturing was fundamentally transformed, especially in Great Britainand some areas of Northern Europe A flurry of technological innovations revolutionized production.Employers brought dozens, even hundreds of workers together in large factories to use newmachinery, new energy sources, and new forms of organization Power looms and mechanicalspinners transformed the textile industry Improvements in the use of water power, and eventually thedevelopment of steam power, made the machinery more powerful still The Industrial Revolution andthe rise of the modern factory system meant that the new industries could undercut competitors invirtually every market, which made mercantilist barriers to trade either irrelevant or harmful

Great Britain led the way in gradually jettisoning mercantilism As British militarypredominance was secured, both Crown and Parliament were less concerned about tight colonialcontrol Many in Britain had indeed, as far back as the American Revolution, begun to regard the cost

of keeping the colonies as outweighing the benefits As Parliament, increasingly representative ofbusiness and middle-class interests, imposed ever greater restrictions on royal prerogatives, itincreasingly challenged the royally chartered monopolies

As the British economy evolved, dissatisfaction with mercantile controls grew Britishindustrialists wanted to eliminate the country’s trade barriers Removing restrictions on importswould allow British producers access to cheaper inputs and would give British consumers access tocheaper imported food, which would allow factory owners to pay lower wages without reducingworkers’ standard of living At the same time, industrialists believed that removing trade restrictionswould increase world demand for British goods For these reasons, Britain’s manufacturing classesand regions developed an antipathy to mercantilism and a strong desire for free trade

As the city of London became the world’s financial center, it added its influence to that of otherfree-trade interests Britain’s international bankers had a powerful reason to open up the Britishmarket to foreigners: the foreigners were their customers American or Argentine access to thethriving British market would make it easier for Americans and Argentines to service their debts toLondon The industrial and financial interests mounted a concerted attack on what antimercantilistcrusader Adam Smith called “the mean and malignant expedients of the mercantile system.”5 By the

1820s those “malignant” mercantilist expedients were under constant challenge.

The battle over mercantilism was joined especially over the Corn Laws, tariffs imposed duringthe Napoleonic Wars on imports of grain.6 Industrialists and financiers opposed the agriculturaltariffs, as did the urban middle and working classes, and were opposed by the country’s powerfulfarmers The free traders won after a protracted struggle They might not have prevailed had there notbeen a major reform of British political institutions: a changed electoral system that reduced thepower of farm constituencies and increased that of the cities and their middle-class residents Evenwith the electoral reforms in place, the final votes in 1846 and 1847 were extremely close and torethe Conservative Party apart A few years later, Parliament repealed the last vestiges of Britishmercantile controls on foreign trade

T HE C LASSICAL E RA : F REE T RADE AND THE G OLD S TANDARD

After Britain, the world’s most important economy, discarded mercantilism, most of the other majoreconomic powers followed suit In 1860, France joined Great Britain in the Cobden-ChevalierTreaty, which freed trade between them and helped draw the rest of Europe in this direction As theGerman states moved toward unification in 1871, they created a free trade area among themselves,then opened trade with the rest of the world Many New World governments also liberalized trade, asdid the remaining colonial possessions of the free-trading European powers Mercantilism was dead,and integration into world markets was the order of the day.7

Over the course of the nineteenth century, much of the world opted for general openness to theinternational economy and for a reduced level of state involvement in the economy Althoughmercantilism had been marked by a strong role for the government in both domestic and internationaleconomic affairs, the classical order that arose over the course of the 1800s saw a dramatic reduction

in government involvement on both dimensions

Technological change dramatically reduced the cost of international economic exchange, making

an open economy that much more attractive Over the course of the century telegraphs, telephones,steamships, and railroads replaced horses, carrier pigeons, couriers, and sails The railroadfundamentally changed the speed and cost of carrying cargo over land The steamship revolutionizedocean-going shipping, reducing the Atlantic crossing from over a month in 1816 to less than a week in1896

The new technologies took hold and diffused very rapidly, even in developing regions In 1870,

Latin America, Russia, Canada, Australia, South Africa, and India combined had barely as much

railroad mileage as Great Britain By 1913, these regions had ten times Britain’s railroad mileage.Argentina alone went from a few hundred miles of rail in 1870 to a system more extensive thanBritain’s.8 On the seas, there was a twentyfold increase in the world’s shipping capacity during thenineteenth century.9

These advances reduced the cost of land transportation by more than four-fifths and of sea-goingtransport by more than two-thirds Europe flooded the world with its manufactures and was in turnflooded with farm products and raw materials from the prairies and the pampas, the Amazon andAustralia Over the course of the 1800s, the trade of the advanced countries grew twice to three times

as fast as their economies; by the end of the century, trade was seven or eight times as large a share ofthe world’s economy as it had been at the beginning of the century.10

International investment also soared As telegraphy allowed information to be transmittedinstantaneously from any reasonably developed area to investment houses and traders in London,Paris, and Berlin, new economic opportunities attracted the interests of European savers like neverbefore Foreign capital flooded into rapidly growing regions in the New World, Australia, Russia,and elsewhere By the early 1900s, foreign investments, largely in bonds and stocks, accounted forabout one-third of the savings of the United Kingdom, one-quarter of France, and one-tenth ofGermany.11 This was also an era of virtually free international immigration, at least for Europeans.Some fifty million Europeans moved abroad, along with another fifty million Asians Markets forgoods, capital, and labor were more tightly linked than they had ever been.

Perhaps the most striking, and most powerful, organizing principle of global capitalism duringthe nineteenth century was the gold standard After centuries of stable bimetallism, in the 1870sgovernments were faced with a choice New silver discoveries drove the price of silver down andmade the existing rate of exchange between the two metals unstable, so governments had to eitherchange the rate or choose between gold and silver Meanwhile, as international trade and investmentgrew, gold—the traditional international medium of exchange—became more attractive than domesticsilver Finally, Great Britain had been on gold since 1717, and its status as the global market leaderattracted other countries to use the same system In the 1870s most major industrial countries joinedthe gold standard, with more countries joining all the time By the early 1900s, the only two countries

of economic importance not on gold were China and Persia

When a country’s government went “on gold,” it promised to exchange its currency for gold at apreestablished rate This provided an important degree of predictability for world trade, lending,investment, migration, and payments The impact on trade was substantial; being on gold in thisperiod is variously estimated to have raised trade between two countries by between 30 and 70percent.12 The gold standard was even more important for international finance than it was for trade.International financiers regarded being on gold as an obligation of well-behaved members of theclassical world economy, a signal of a country’s economic reliability.13 Investors had good reasons

to focus on government commitments to the gold standard The balance of payments adjustmentmechanism under the gold standard might require a government whose economy was running apayments deficit to reduce wages and spending to move back toward balance To stay on gold,governments had to be able to privilege international ties over domestic demands, imposing austerityand wage cuts on unwilling populations if necessary This made the gold standard a litmus test thatinternational investors used to judge the financial reliability of national governments.14 Membership

in the gold club conferred a sort of blessing on its initiates, and gave participating countries access to

an enormous pool of international savings

Technological and policy change turned a world of closed colonial empires into an integratedglobal economy The results were impressive by almost any standard Transportation andcommunications improvements, along with policies to further economic integration, led to asignificant convergence of prices.15 This in turn created important opportunities for countries to gainaccess to world markets for goods and capital As railroads, steamships, and eventually refrigerationbrought grain and beef prices in Omaha and Buenos Aires up toward European levels, ruralbackwaters quickly became some of the most attractive places in the world to farm and invest

Economic integration also led to convergence of levels of development, as many of the countriesdrawn into this new world economy grew very rapidly Industrialization spread from itsNorthwestern European homeland to the rest of Europe and much of the world Great Britain was

overtaken: in 1870, British iron and steel production was greater than that of Germany and the UnitedStates combined, while by 1913 Germany and the United States combined outproduced the UnitedKingdom roughly six to one This was true also of living standards: per capita incomes in the UnitedStates, Australia, and New Zealand were higher than in the United Kingdom, and Argentina andCanada were gaining fast.16 Although there were periodic panics and recessions, the 100 years from

1815 to 1914 were marked by a general macroeconomic stability that matched the general stability of

diplomatic affairs—which is why the era is often called the Hundred Years’ Peace or the Pax

Britannica.

Whatever its economic achievements, there were plenty of evils in the classical era The end ofmercantilism was associated with a decline of the early colonial empires, especially in the NewWorld But in the 1880s, the major powers began accumulating new colonial possessions Europe’scolonialists divided most of Africa, Southeast Asia, and East Asia among themselves (and Japan); theUnited States joined the fray in the Pacific and the Caribbean Many of the new empires were run onlines reminiscent of mercantilism, giving preferential treatment to the colonial power’s economicinterests, although the monopolistic features were typically more muted Some colonies wereafforded reasonable treatment; but some were mercilessly exploited The horrific abuses ofBelgium’s King Leopold in the Congo were particularly egregious (Hochschild 1998) In part as aresult, many parts of the world—especially in Africa and Asia—stagnated or declined economicallyeven during the best of times

The classical economic order was also no political idyll Leaving colonialism aside, politicalrights were severely limited even in the industrial world Most of the developed nations made nopretense of being democratic; those that did had such restricted franchise and limited freedom thattoday we would not consider them democratic Indeed, limited political voice by farmers and themiddle and working classes may well have been essential to the ability of governments to play by therules of the classical game: it is hard to imagine truly representative governments being able toimpose the austerity measures necessary to sustain economic openness in a world largely withoutsocial safety nets

The economic dislocations created by economic integration were also not trivial As cheap farmproducts flooded into Europe from the New World, Australia, Russia, India, and elsewhere, most ofthe Continent’s farmers were made redundant For decades, much of Europe suffered through awrenching agrarian crisis Tens of millions left the land to resettle in the cities or move abroad.Others demanded protection from imports, and sometimes governments provided this Foreigncompetition also harmed many traditional producers in the developing world, who could not competewith inexpensive factory products

Nonetheless, despite problems and challenges, a recognizable economic order prevailed overmost of the world in the nineteenth and early twentieth centuries This order was almost the diametricopposite of mercantilism Where the mercantilist system was based on aggressive closure of homeand colonial markets to foreigners, the norm in the classical period was of openness to internationaltrade, investment, and migration Where mercantilism presumed extensive government intervention inthe economy, both at home and abroad, governments in the classical system tended—with variations

—to leave markets largely to their own devices Both international openness and a market orientationwere debated and contested, but both prevailed most of the time and in most countries

The classical international economic order that reigned in the nineteenth and early twentiethcenturies has to be considered generally successful The world economy as a whole grew more in the

75 years before 1914 than it had in the previous 750 There was a great deal of convergence as many

poorer countries grew more rapidly than rich countries Goods, capital, technologies, information,ideas, and people moved quite freely around the world Macroeconomic conditions were stableoverall, economic relations among the major economic powers were generally cooperative, and therewas a broad consensus about the desirability of sustaining an open world economy.

T HE I NTERWAR C OLLAPSE

Despite the achievements of an integrated international economy in the previous century, it came to anend with World War I, and efforts to re-create it failed for the next twenty years Instead, capitalismturned inward, in some cases toward the most insistently nationalistic policies in modern history Inmuch of the world, a general trend toward engagement with the world economy and in the direction ofminimal government involvement in markets was reversed almost completely

World War I had two profound and lasting effects The first was to shift the center of gravity ofthe world economy definitively away from Europe and toward the United States The war absorbedthe energies of the European belligerents and drew them out of their colonial possessions The UnitedStates rushed into the vacuum this created, supplying the belligerents with everything from food toweapons and supplanting the Europeans as principal traders, lenders, and investors in much of thedeveloping world By 1919, the United States had gone from being the world’s largest debtor to itsleading lender, and it was also the arbiter of the economic and political settlement worked out amongthe warring parties at Versailles

The second enduring effect of the war was to change the political landscape of Europe Althoughpolitical institutions had gradually become more representative over the course of the previouscentury, on the eve of the war they remained quite limited The war led to a remarkable increase inthe depth and breadth of democratic reform, especially in Europe In part this was due to the collapse

of four autocratic empires—the Russian, Austro-Hungarian, Ottoman, and German—and theirreplacement by successor states, many of which were democratic In part, democratization was adirect result of belligerent governments’ attempts to garner support for the war effort, in particularfrom socialist parties and their working-class bases of support Many European governmentsrewarded popular backing for the war with some combination of political representation, socialreform, and labor rights By the early 1920s almost every industrialized nation was governed by acivilian democracy with universal male suffrage, and many had universal female suffrage as well.Largely as a result, over the course of the interwar years, Europe’s socialist parties—generallyanathema, often illegal, before 1914—were parliamentary fixtures and frequent members of rulingcoalitions

The rise to economic predominance of the United States had a number of implications Itsymbolized a significant change in the nature of modern capitalism By the 1920s, the United Stateshad pioneered a path soon followed by other industrial nations,—toward an economy dominated bymass production and mass consumption Some of this was the result of economic growth As incomesrose, the demand for consumer goods beyond food, clothing, and shelter grew, especially to includemore sophisticated consumer durables—including such recently invented ones as the radio, thephonograph, the telephone, the refrigerator, and the automobile More and more of what industryproduced was aimed at the general public

The ways industry produced evolved along with its products Technological advances inproduction, especially the spread of electricity and electrical machinery, drove increases in the scale

of manufacturing, including the use of the assembly line Organizational developments gave rise to themodern multiplant corporation, integrating many stages of the production process; some of the newindustrial corporations became multinational Corporations grew, and oligopolies came to dominatemany markets At the same time, labor unions organized much larger shares of the labor force.

Where the typical industrial economy of the nineteenth century was characterized by small firms,family farms, and unorganized workers, by the 1920s most major industrial economies weredominated by oligopolistic corporations and organized labor unions Modern societies were driven

by big business and big labor The automobile industry was both typical of and in the forefront of thechange: by the 1920s, motor vehicle production was the largest industry in most developed societies;the sector was dominated by large corporations and, in many instances, large labor unions

In addition to the more general impact of American-style capitalism, the economic rise of theUnited States had some more specific effects The United States largely determined the shape of thepostwar settlement, as the Treaty of Versailles that ended the war largely followed the proposals ofU.S President Woodrow Wilson These included institutionalized cooperation among the majorpowers, on economic issues as well as others But almost as soon as the American blueprint was put

in place, with the League of Nations and a series of monetary and economic conferences, the UnitedStates turned its back on the rest of the world In 1920, a Republican Party committed to

“isolationism” swept the presidency and both houses of Congress The isolationists were hostile tointernational cooperation on economic matters that they felt would compromise U.S autonomy

The United States remained the most important trading, investing, and financial center in theworld, but the government largely withdrew from international economic affairs The impact of thiswas compounded by the enduring hostility among the former European belligerents This made itextremely difficult for the major economic powers to work together on international economic issues

The difficulties of interwar cooperation, and a more detailed examination of earlier experiences,demonstrated the importance of purposive collaboration to maintain an open international economicorder During the classical era, there had been a widespread belief that an integrated world economywas self-regulating and self-sustaining Although this may have been true of some markets, and to alimited extent to the operation of the gold standard, it was clearly not the case with the globaleconomic order itself There had been very substantial cooperation among the major financial andmonetary centers, especially in times of crisis Monetary authorities lent substantial amounts toforeign governments facing financial difficulties and helped organize concerted efforts to stabilizemarkets

More generally, the classical international economic order had depended on the willingness andability of participant governments to adjust their domestic economic activities to internationaleconomic conditions This meant, most important, allowing and reinforcing the austerity measuresrequired to restrain—even reduce—wages and prices as necessary to maintain a national commitment

to the gold standard This in turn was possible due largely to the fact that those principally affected bythis austerity—farmers, workers, the middle classes—tended to be underrepresented, or notrepresented at all, in the political systems of the classical era

But the spread of democracy after World War I meant that most industrial-country governmentsfaced substantial political opposition to attempts to impose gold standard–style adjustments.17 Unlike

in the nineteenth century, by the 1920s farmers, workers, and the middle classes were wellrepresented in national political systems and strongly resisted adjustment measures that had beenimposed with relative ease in an earlier era The classical system had been based on a consensusamong elites in favor of an open international economic order The national political economies that

emerged from World War I largely lacked such a consensus.

The interwar years were marked by almost continual conflict among the major economies.Attempts at monetary cooperation were largely inconclusive or failures Trade policies tended tobecome more protectionist over time Important financial problems—such as war debts owed by theAllies to the United States, or reparations owed by the Germans to the Allies—created continualfrictions

Over the course of the 1920s, as economies recovered rapidly, political difficulties seemed lessimportant At the start, the immediate postwar years were very difficult in Central and EasternEurope The new successor states struggled to put their economies on a sound financial footing, oftenafter suffering through several years of very high and hyperinflation By the time Germany’shyperinflation was brought to an end in 1923, the price level was one trillion times what it had been

in 1919 But by 1924, economic growth had been restored in most of the Continent and in the rest ofthe world Over the next few years, countries gradually came back to the gold standard, internationalinvestment reached and surpassed the prewar levels, and international trade grew rapidly LatinAmerica and many of the more advanced colonies increased their primary exports dramatically andregained access to international capital markets—especially to loans from the new U.S lenders Itappeared that the world economy had been restored in something similar to its former conditions

However, the underlying weaknesses of the post–World War I settlement became painfullyobvious when crisis hit in 1929 What started as a minor recession dragged on and on, exacerbated bygrowing conflict among the major financial centers Debtors in Latin America and Central andEastern Europe defaulted, exacerbating financial distress Financial and currency crises raced throughEurope, eventually driving most of the region’s countries off gold Desperate governments raisedtrade barriers, imposed capital controls, and restricted currency convertibility in an effort to combatthe growing crisis

From 1929 until 1936, virtually every attempt at a cooperative response to the crisis failed.Meanwhile, insistent government attempts to implement the kind of austerity measures that hadworked reasonably well in the classical era ran into economic and political obstacles Economically,gold standard–style adjustments had been relatively rapid in the nineteenth-century environment ofsmall firms, small farms, and unorganized labor, which made for quite competitive markets andflexible prices and wages But in the conditions of the 1930s, with industrial economies dominated bylarge firms in oligopolistic markets and well-organized labor unions, prices and wages were muchless flexible As a result, attempts to bring the economy back into balance by reducing wages andprices largely failed Even when prototypical adjustment succeeded, in the new conditions it created

a vicious circle that Irving Fisher called “debt deflation,” in which deflation raised real debt burdens,which caused further bankruptcies and further deflation (Fisher 1933) Attempts to hew to goldstandard orthodoxy simply worsened the downward spiral—and often heightened political tensions

The new political realities of the industrial world also affected responses to the crisis that began

in 1929 Governments could no longer ignore the impact of the crisis, or of austerity measures, onfarmers, the middle classes, and the working classes, for these groups were now well represented innational politics Attempts to fit national economies to their international commitments ran intopowerful political opposition and often ended with the toppling of the government that tried to do so,whether by democratic or authoritarian means

The result almost everywhere was a turn inward in trade, finance, and investment In Southern,Central, and Eastern Europe, Japan, and Latin America, governments imposed high trade barriers,defaulted on their foreign debts, left the gold standard, and slapped on capital controls Governments

in these nations also typically began to play a more directive role in economic affairs, sometimesnationalizing large portions of the economy The Soviet Union, which had jettisoned capitalism in

1917 but permitted some aspects of a market economy to persist, shut down these vestiges andembarked on a forced march toward industrialization under central planning The order of the daywas autarky—a classical Greek term recoined to mean a purposive economic policy of national self-sufficiency: trade protection, capital controls, an inconvertible currency This was usually carried out

by an authoritarian government—fascist in Central and Eastern Europe, communist in the SovietUnion, nationalist in Latin America—as almost all the preexisting democracies were swept away

The new autarkic governments changed direction toward heavy-handed intervention in theeconomy and international economic relations, so much so that the policy was sometimes, and withsome justification, called “neomercantilist.” Yet developing and semi-industrial countries couldhardly be faulted for falling back on their own resources: international trade dropped by two-thirdsbetween 1929 and 1932, international finance was dead in the water, and the gold standard hadlargely been abandoned by its strongest proponents The autarkies could, with some reason, argue thattheir turn inward was driven by the failure of the global capitalist economy

Most of the principal economic centers had also largely abandoned their internationalcommitments In 1931, Great Britain left the gold standard, after more than two centuries on it, and sodid most of Europe; the United States followed in 1933 Governments everywhere increased tradeprotection; even formerly free-trade Britain built tariff walls around its empire Every attempt tocobble together some semblance of cooperation among the major economic powers failed

It was only late in the 1930s that an alternative to autarky began to emerge in Western Europeand North America Governments in these areas—which had largely remained democratic amid theflowering of authoritarianism—expanded their social policies, experimented with countercyclicalmacroeconomic policies, and gradually increased the role of the public sector The new model,which eventually gave rise to the modern social democratic welfare state, attempted to blend marketswith regulation, an open economy with social insurance The governments involved also, by 1936,were recommitting themselves to international cooperation in commercial and monetary affairs, trying

to bring down trade barriers and stabilize currencies These attempts were halting and preliminary,but they pointed the way toward a new economic policy synthesis General sympathy for a marketeconomy and international economic integration coexisted with substantial government involvement

in the economy, especially in macroeconomic management and social policy

S ECOND C HANCE : T HE B RETTON W OODS S YSTEM

Even as World War II raged, the Allies planned the postwar economy, hoping not to repeat theexperience of the aftermath of World War I This time around, the United States was committed toboth building and sustaining an open international economy—and although there remained plenty ofisolationist Americans, postwar governments stayed this course The result was the first internationaleconomic order whose general contours had largely been planned by governments, in this case theU.S and British governments Because the final negotiations over the arrangement were held in July

1944 at a resort in Bretton Woods, New Hampshire, it became know as the Bretton Woods System.The Bretton Woods System reflected a general commitment by the capitalist allies (not theSoviet Union), and eventually by virtually all of the advanced industrial capitalist nations, to an openinternational economic order All developed parties to the agreement shared the goal of generally free

trade and investment and stable currency values As the system evolved, the General Agreement onTariffs and Trade (GATT, eventually succeeded by the World Trade Organization, WTO) oversaw aprocess of gradual trade liberalization The International Monetary Fund (IMF) supervised monetaryrelations among member nations, providing balance of payments financing and encouraging generallystable exchange rates The International Bank for Reconstruction and Development (IBRD or WorldBank) financed long-term infrastructure projects that would facilitate private investment indeveloping countries Together, these three Bretton Woods institutions watched over an integratedcapitalist world economy, which would avoid the protectionism, financial disarray, and currencyvolatility of the interwar years (The Soviet Union and its allies were not included in this system, asthey had opted out of international capitalism.)

The Bretton Woods monetary order was centered on the U.S dollar, fixed to gold at $35 anounce Other currencies were fixed to the dollar but could be varied in the event “fundamentaldisequilibria” (never clearly defined) dictated a devaluation or revaluation This was meant toprovide both the currency stability that had been lacking in the interwar years and the flexibility thathad been lacking in the classical era In this way, it was something of a compromise Governmentswere expected to abide by the rules of the balance of payments adjustment game, but not at theexpense of important national economic goals

The Bretton Woods System was replete with this sort of compromise The system itself was, inthe broadest sense, meant to reconcile a national commitment to economic integration with a parallelnational commitment to demand management and the social democratic welfare state These two sets

of commitments had largely been seen as inconsistent under the gold standard and during most of theinterwar period, but appeared both economically and politically desirable and obtainable by the1940s.18 There were other compromises as well Although trade was liberalized, this was achievedonly gradually Not only that, but agricultural and services trade were not included, the developingcountries were exempt, and there were many escape clauses written into the agreements, whichallowed governments to impose trade barriers in certain circumstances The same spirit ofgradualism and compromise was clear in financial affairs: although there was a general belief in thedesirability of free capital movements, virtually all governments imposed capital controls of one sort

or another to manage international payments

The Bretton Woods System governed relations among the industrialized capitalist economiesfrom the late 1940s until the mid-1970s Over these twenty-five years, the capitalist world grew morerapidly that it had at any time in history Real per capita GDP had risen 1.3 percent a year between

1870 and 1913, a rate vastly higher than anything previous seen; after dropping below 1 percent ayear in the troubled interwar period, from 1950 to 1973 GDP per capita grew by more than 2.9percent a year—more than twice as rapidly as during the classical age This average was broughtdown by relatively slow growth in the developing world: Western Europe’s GDP per person grew bymore than 4 percent a year, Japan’s by more than 8 percent a year Even though the developing andnoncapitalist worlds largely withdrew from international commerce, world trade overall grew twice

as fast as world output.19 There is little question that this compromise between nationalmacroeconomic management and international economic integration was extraordinarily successful

The less developed countries (LDCs) of Asia, Africa, and Latin America did somewhat lesswell Latin American nations were hit hard by the Great Depression and spent most of the subsequenttwenty years building self-sufficient national markets To some extent, this was forced on them by theDepression, World War II, and postwar reconstruction, all of which limited their foreign economicopportunities But even after wartime conditions faded, Latin American governments maintained and

increased their barriers to trade with the rest of the world They did permit foreign direct investment

by multinational corporations, but their principal policies were associated with what has been calledimport substituting industrialization (ISI), a systematic attempt to encourage domestic manufacturing

to replace previously imported manufactured goods Governments imposed high trade barriers,subsidized domestic manufacturing, taxed exports, took over large portions of basic industry, andgenerally biased economic incentives against exports and toward production for the domestic market

As they decolonized, most of the former European colonies in Africa and Asia followed theLatin American example and pursued ISI The result was a world largely divided in three parts: theindustrialized capitalist nations, gradually increasing economic ties among themselves; thedeveloping capitalist nations, growing quite separately from the world economy; and the centrallyplanned economies of the communist nations, which rejected most ties with the capitalist world Each

of these three segments of the world economy represented a different mix of state and market,openness and closure The centrally planned economies rejected both markets and internationaleconomic integration The capitalist LDCs accepted markets domestically, but their governmentswere deeply involved in their national economies and also cordoned themselves off from the rest ofthe world The industrial capitalist countries pursued a modest compromise between state and market

at home, and a general if restrained commitment to international economic integration

F ROM B RETTON W OODS TO G LOBALIZATION

These three approaches appeared stable for several decades But over the course of the 1970s, eachran into difficulties Over the course of the 1980s, all were fundamentally transformed The resultwas a more inclusive—indeed, virtually global—and heightened trend toward international economicintegration

The Bretton Woods monetary order was strained by the late 1960s This was primarily due todivergence between monetary conditions in the rest of the industrial world, on the one hand, and theUnited States, on the other U.S spending on the Vietnam War and expanded social programs werecontributing to a higher rate of inflation in the United States than in Europe, which underminedconfidence in the dollar Austerity measures could have brought down inflation and restoredconfidence, but the U.S government was reluctant to sacrifice its domestic macroeconomic policyautonomy to maintain the gold–dollar link, even if this link was the centerpiece of the Bretton Woodsmonetary system In August 1971, the United States broke the link and devalued the dollar, ending theBretton Woods era of fixed but adjustable exchange rates

Another source of tension in the Bretton Woods system was, ironically, due to its success inrekindling international financial markets While foreign direct investment had continued through thepostwar period, international financial flows had effectively stopped in 1929 and stayed minimaluntil the 1960s As macroeconomic stability and economic growth were restored, financialinstitutions rediscovered foreign operations By the early 1970s, international financial markets werelarge and growing, and the increased level of international financial flows helped undermine the fixedexchange rate regime by heightening speculative pressures on some currencies (including the U.S.dollar)

Once the Bretton Woods exchange rate arrangement ended, most major currencies began floatingfreely against one another This loosened the previous monetary straitjacket, and a bout of inflationarypressures ensued On top of this, in 1973 a cartel of oil producing nations (the Organization of

Petroleum Exporting Countries or OPEC) quadrupled the price of petroleum, putting further upwardpressure on prices A deep recession in 1973–75 led to an unaccustomed mixture of highunemployment and high inflation—stagflation, as it was called Inflation continued to rise, aggravated

by another round of OPEC oil price increases in 1979–80

The rebirth of international finance also made foreign lending newly available to developingcountries, which had been frozen out of capital markets for forty years, and a burst of LDC borrowingensued By the early 1980s, a dozen or so developing countries had accumulated substantial debts tocommercial banks in Europe, North America, and Japan

Macroeconomic difficulties came to a head after 1979 The developed countries began to adoptmore contractionary monetary policies to slow the rate of inflation This led to extremely high interestrates and several years of recession The spike in interest rates and global recession threw the LDCdebtors into a severe debt crisis, which took many of them the better part of the decade to resolve.Meanwhile, while inflation was brought down in the advanced capitalist countries, unemploymentremained at very high levels The centrally planned economies, too, had been experiencing stagnantgrowth, and their economic and political systems came under ever greater strain

In this crisis atmosphere, the developed countries gradually moved to recommit themselves to amarket orientation and international economic openness Governments exercised greater monetaryrestraint, deregulated many economic activities, and privatized previously public enterprises Thetrend was epitomized by the policies of British Prime Minister Margaret Thatcher and U.S PresidentRonald Reagan, who made the case for less government involvement in their respective economies.Reagan did so, anomalously, while running up enormous budget deficits in the United States.Nonetheless, and despite such setbacks as a costly banking crisis, by the mid-1980s the developedcapitalist countries had made clear their reinforced dedication to an integrated international economy.The developing countries, for their part, emerged from debt and related crises with a new-foundorientation toward international markets To be sure, some few LDCs, especially in East Asia, hadbeen following an export-led strategy, but until the 1980s ISI had been the almost universal policychoice of developing nations The debt and oil crises, along with the accumulated problems ofrelatively closed markets in an increasingly open world economy, led almost every country in LatinAmerica, Africa, and Asia to jettison the prior inward orientation in favor of much more economicopenness to the rest of the world Developed and developing capitalist countries continued to reducebarriers to trade and investment, leading to a characterization of the era as one of “globalization.”

The most stunning development on the path to globalization was the collapse of the centrallyplanned economies The economic problems of the late 1970s and early 1980s eventually drove thesecountries away from central planning and toward international markets China and Vietnam were thefirst to move, in 1979: while maintaining communist rule, both governments reoriented theireconomies toward exporting to the capitalist world After 1985, the Soviet Union embarked on anattempt at gradual reform, which was quickly overtaken by events as the country’s social and politicalsystem unraveled After the Soviet Union collapsed in 1991, the entire Soviet bloc quickly gave upcentral planning and moved toward capitalism at speeds varying from gradual to breakneck

Along with globalization came a renewed interest in regional economic blocs The EuropeanUnion (EU) added a whole host of new members, until it encompassed virtually all of Europe.Meanwhile, by 1992 the EU had put in place a single market that eliminated barriers to the movement

of goods, capital, and people and that harmonized the regulation of investment, migration, product andproduction standards, professional licensing, and many other economic activities A subset of EUmembers went a step further in 1999, creating a single currency, the euro, and a common European

Central Bank The United States, Canada, and Mexico formed a free trade area in 1994, as did Brazil,Argentina, Uruguay, and Paraguay All over the world, countries rushed to open their borders,increase their exports, attract foreign capital, and strengthen their economic ties with each other.

By the beginning of the twenty-first century, the modern world economy looked strikingly similar

to the classical order of the beginning of the twentieth century International trade, investment, andfinance were generally free from government restrictions Most governments limited their intervention

in markets and in international economic transactions Migration was less free than it had been, andthere was no overarching monetary standard, but otherwise there were many similarities to conditions

a century earlier Capitalism was global, and the globe was capitalist

Global capitalism had, however, changed profoundly in the intervening years Today, there issubstantial government involvement in the economy, both in macroeconomic demand management and

in the provision of a wide array of social insurance and other social programs This is true of alldeveloped countries and of many developing countries as well The social democratic welfare state

is now the norm rather than a novelty, and despite periodic objections it seems unchallenged as thestandard organizational form of a modern capitalist political economy

Just as contemporary capitalism incorporates substantial government supervision of nationaleconomic activities, it is also characterized by a dense network of international institutions Some areregional, such as the European Union Many are global, such as the IMF and the WTO The informalcooperative arrangements of the gold standard era have given way to a much more complex array offormal international organizations

However successful the contemporary economic order may be, it has not eliminated problemsthat have plagued capitalism since its beginnings Foremost among these is the recurrence of periodiccrises A deep recession that began late in 2007 served as a reminder that financial and commercialties among countries can transmit crises—even panics—from market to market with lightning speed.The crisis of 2007–10 also highlights the role of international financial flows, as it was in large partthe result of a decade of very substantial cross-border lending and borrowing (Chinn and Frieden2011) Financial and currency crises, it seems, are the price of open financial markets

Although contemporary capitalism has been associated with rapid economic growth in manyparts of the world—most strikingly, in communist-ruled China—there are still many parts of thedeveloping world that remain mired in poverty Whether this is due to excessive or insufficientreliance on markets or excessive or insufficient integration into the world economy remains a topic ofhot debate This is not surprising It is almost certainly in the nature of capitalist political economiesthat there will be enduring conflicts over how and how much government should intervene in marketsand how tightly and on what terms national economies should be tied to the world economy

Over the past five centuries, capitalism has gone from being a novel economic system in a smallregion in Western Europe to being the prevailing form of economic organization in the whole world.The rise and eventual triumph of capitalism on a global scale has been associated with the most rapideconomic growth in world history It has also been associated with spectacular crises, wrenchingconflicts, and a great and growing gap between the world’s rich and the world’s poor Globalcapitalism holds out the hope of extraordinary social and economic advances, but it must address itsweaknesses to realize these advances

N OTES

1 Rostovtzeff (1960) is the best-known argument for Rome’s capitalism Temin (2006) presentsstrong evidence for the operation of markets in the Roman empire but does not explicitlyconsider whether the society should be considered capitalist.

2 Cited in Viner (1948)

3 On a more arcane but still important note, as Keynes pointed out (1936, chapter 23), themercantilist emphasis on bullion and on a trade surplus served to increase the money supply(in a specie-based monetary system) and to reduce borrowing costs In societies heavilyoriented toward entrepreneurial activities and novel endeavors, the “shortage of money” (highinterest rates) was seen as a major brake on progress In fact, some of the protectionistmeasures associated with mercantilism may have been triggered by the emphasis onincreasing the money supply to lower interest rates, which would of course also have raiseddomestic prices

4 Classic analyses are Ekelund and Tollison (1981) and Ekelund and Tollison (1997)

5 Smith (1776, Book Four)

6 For the definitive analysis, see Schonhardt-Bailey (2006)

7 The remainder of this essay draws loosely on material in Frieden (2006) See that referencefor many more details

8 Maddison (1995, p 64)

9 Stamp (1979); Mathias and Pollard (1989, p 56); Maddison (2001, p 95)

10 Maddison (1995, p 38) For an excellent survey of the period, see Marsh (1999)

11 O’Rourke and Williamson (1999, p 209)

12 See, for example, Estevadeordal et al (2003) and López-Córdova and Meissner (2003)

13 Bordo and Rockoff (1996, pp 389–428)

14 Eichengreen (1992); Eichengreen and Flandreau (1997) The presentation here is greatlysimplified Governments generally tried to manage their economies so as to avoid majorgold flows This could involve trying to retain gold by raising interest rates, which wouldtend to keep money at home to take advantage of the higher rate of return Or it couldinvolve trying to brake domestic wages, prices, and profits, so as to make exports morecompetitive Nonetheless, these policies had their origin in the pressures that being on goldexerted on national economies and national governments

15 O’Rourke and Williamson (1999, pp 43–53) See also Capie (1983)

16 The classic summary of the technological aspects of the process is Landes (1969, pp 231–358)

17 Eichengreen (1992) is the canonical analysis of the period

18 Ruggie (1982) is the classic statement of the argument

19 Maddison (2001)

R EFERENCES

Bordo, Michael, and Hugh Rockoff “The Gold Standard as a ‘Good Housekeeping Seal of

Approval.’” Journal of Economic History 56 (June 1996): 389–428.

Capie, Forrest, H “Tariff Protection and Economic Performance in the Nineteenth Century.” In

Policy and Performance in International Trade, ed John Black and L Alan Winters1-24.

London: Macmillan, 1983